What Everyone Ought to Know About Leverage
Everyone wants to grow their nest egg. The easiest way to do that is through compounding of gains over time. Unfortunately, most of us don’t have the patience to follow that plan. Luckily, finance wizards created leverage.
This post will explain leverage, common uses, and keys to using it. Be warned - leverage is a mighty tool. It can speed up money pile growth, or it can wipe you out completely. With great power comes great responsibility!
What is Leverage?
Merriam-Webster defines leverage as:
- The action of a lever or the mechanical advantage gained by it
- Power, effectiveness
- The use of credit to enhance one’s speculative capacity
#3 is what matters to us.
Simply put, leverage is the use of credit( debt ) to increase an asset base to amplify investment returns.
Common Uses of Leverage
Making a home purchase is the most widely used form of leverage. When your bank requires a 20% down payment, they are allowing you to lever that 20% into a larger amount of money. The expectation is you will pay them back plus interest.
20% down payment on a $1mm home = $200,000 out of pocket cost.
Your $200,000 gets you an additional $800,00 from the bank to complete the purchase, and you enjoy living in your new home!
In this example, if you did not want to use leverage. Your only other option would be to pony up the full $1mm.
Buying A Business
Leverage can also be used to purchase a business. The key is to find sellers and lenders who will allow you to use it.
Some business transactions come with seller provided financing. For the ones that don’t, you would need to be a full cash buyer. That means finding a lender who will provide money to complete the purchase.
Be prepared, business lenders will likely require a substantial cash down payment. A 50% cash deposit, or more, is not uncommon when you want to buy a business with help from a third party lender.
Business Equipment Purchase
Purchasing equipment for your business can also be done using leverage. Lenders who are in this space may not only require a cash deposit. But also higher interest rates or percentages of revenue during payback. Some hard money equipment lenders will also only lend on equipment they know they can use if you can’t pay them back.
Tip for Buying Business Equipment
Consider the SBA (Small Business Administration) if you are looking to purchase equipment. They can help match you to lenders, assist with terms, and give overall guidance.
There is a robust market for this type of lending and companies are able to buy equipment to grow their businesses by employing leverage.
When you own a portfolio of cash, stocks and bonds your broker or custodian will usually offer you leverage in the form of margin. This means they are willing to offer you a loan above what your total account is worth so you can increase your buying power.
The benefit to investors in using margin is that they can buy assets without paying the full purchase price.
Deposit $10,000 into a brokerage margin account = $20,000 worth of buying power
Without the use of margin, you would be capped at buying securities worth $10,000 per the cash deposit.
While this sounds like you are getting free money, you do pay interest on the loan. You are also at risk of margin calls if the purchased securities go down in value. You will see the danger of margin calls later.
To see how grime a margin call can be - watch this clip from the movie “Margin Call” starring Kevin Spacey, Demi Moore & Zachary Quinto.
Wins From Leverage
First Time Home Buyer
First time home buyers face challenges. Not having cash to pay the full asking price is generally problem number one. Luckily thanks to leverage, buyers can still have the opportunity to purchase a home for a fraction of the offer price.
One example is James Merse of Bloomfield, New Jersey. He was quoted in a piece written by Lee Nelson for MyMortgageInsider, “I got a first-time home buyer's loan. So, I only needed to put down 5 percent, which was key for me because coming up with the down payment was difficult initially, considering I still had to pay for life and its challenges (source).”
Without the use of leverage, James and other first time home buyers would likely not be able to buy their first home.
Being an entrepreneur or business owner is a dream for many. Cash is required to start down that path and sometimes people do not have enough to make it happen. Luckily for them, leverage can help them get started.
Sheila Tucker and her partner started The Market Street Pharmacy with their own personal money but needed more for initial renovations and products. They turned to the SBA for funding and were able to secure $200,000 to get the business moving (source).
By leveraging their personal capital to get a loan from the SBA they were able to get their business going!
Trading Margin Can Amplify Return
Hedge fund investors are generally considered the savvyist in the markets. That means they understand how to use leverage to amplify their returns.
Recently, Eisler Capital raised a staggering $1 billion in funds specifically for leveraged bets. They plan to use leverage to 4x their bets in the hopes of raking in a return of 12% - 15%. This is with a goal of doubling their annualized return of ~ 6%.
Based on their backtesting they believe increasing their normal leverage of 1.3x to 4x they could have returned ~25% versus ~ 8% return (source).
It is worth stating that backtesting results are NOT a guarantee of future returns. The proposed increase in margin by Eisler could easily backfire.
You will see how a hedge fund got destroyed by leverage soon enough (below).
Losses From Leverage
2007-2008 Mortgage Crisis
During the early 2000s the use of leverage was skyrocketing. It was most obvious in the housing / mortgage market.
Home prices were climbing and lenders had very lax lending practices. Buyers / investors were often buying more than one property (sometimes 5 or more) with zero money down!
Adjustable rate mortgages added fuel to the frenzy because they allowed people to only pay interest each month keeping borrowing costs low. Then the price bubble burst.
As adjustable rate mortgage payments flew higher. People could no longer afford payments on their properties and crashing home prices meant they could not refinance the debt. Mortgage delinquencies started and foreclosures came next.
The housing bubble crash and following wipe out of buyers helped start the 2007 - 2010 financial crisis aka The Great Recession.
Since then, lending practices have tightened and extreme use of leverage in home buying has been reduced. You can read more about the 2007 - 2008 mortgage crisis and The Great Recession here.
When we noted Eisler Capital’s plan to use leverage to amplify returns. We felt we needed to show you how leverage can ruin an investor as well.
Archegos was a fund that was wiped out earlier in 2021 thanks to using too much leverage. They were holding ~ $50 billion in positions with only $10 billion in capital behind it!
Archegos held concentrated stock bets and when one of the positions started to move lower in price. They were required to produce more capital to cover the margin loans they received from the bank.
When Archegos could not come up with the capital to cover the margin call. They were forced to sell their holdings and take losses. The losses for Archego ended up being $10 BILLION in 2 days! Which forced them to shut down their operation.
Let’s just say the allure of leverage got them.
If you want to get into the gory details of how they built their positions and how banks allowed them to use too much leverage, read our piece “Archegos and How They Blew Up - Margin Call!.”
Ways to Manage Leverage
One of the easiest ways to make sure you use leverage correctly is by not overextending. This means you use it with restraint.
Just because someone is going to give you 10x or 100x the amount of cash you have. It does not mean you need to take it. Consider being very conservative with leverage.
Know When It Can Go Bad
When using leverage or margin with investments there are certain thresholds at which you will need to give more cash to keep your positions. The dreaded margin call. These levels vary by custodian / brokerage company and can change daily.
You need to be aware of when the margin call can come, and plan to either have cash to cover it, or sell your position before the custodian / brokerage forces you too.
Knowledge and preparation can keep you out of trouble.
Targeted Shots on Goal
Sometimes a very compelling opportunity comes your way. If that situation happens and you don’t have the full cash amount to participate. You might want to explore leverage.
If you do, make sure you are not overextending and know when it can go bad. Chalk the use of leverage as a single specific shot on goal.
One of the safest ways to stay away from leverage trouble is by not using it. Yes, being a cash buyer for homes, businesses or securities can be tough. Without the cash, you can’t participate. But that sting of being on the sidelines might save you. Watching hard earned capital disappear by misusing leverage could set you back years.
Leverage can be a powerful tool to generate cash wealth and returns. Yet, when used improperly it can ruin you. The key is to know what opportunities, when, and in the right amounts to use it.
By not overextending yourself you keep it manageable. Knowing when and how it can go bad can help you plan for the worse case scenario. And simply not using it at all can keep you level headed even if you miss an opportunity.
As Richard Branson says, “Business opportunities are like buses, there’s always another one coming.”
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